Accounting Concepts of British Petroleum - Case Study Example

Table of Contents Introduction 2 Company Background 2 Objective 3 Layout (structure) 3 Methodology (methods used) 4 Ratio analysis has been used tocomment on the financial condition of BP. 4 Ratio Analysis 4 Industry ratios 5 Problems/Opportunities and Possible Effect on Future Financial Statements 8 Inventory/Asset Discussion 9 Application of Accounting Concepts 10 Accrual concept 10 Consistency concept 10 Materiality concepts 11 Going concern 11 References 12 Introduction Company Background British Petroleum (BP) was established in the year 1909 by William Knox D'Arcy. The organisation has its operations in 100 countries around the world. BP has a production of 3.9 million barrels of oil equivalent per day. The company is into oil exploration, refining and finally producing various petroleum variants according to the requirements of the consumers. Apart from petroleum, BP has a great reputation in the bio fuel market all over the world. In 2007, BP distributed 800 million US gallons of ethanol and 1 billion US gallons of biodiesel. BP is also expanding its area of operation in the solar energy sector. Presently, the company is contributing $20 million of energy to US department (Solar Technology, n.d.). BP is also focussing on the wind energy sector since the launch of Alternative Energy business in 2005. The company is estimating a production of around 1000 MW (Wind Technology, n.d.). BP has also taken initiatives to control the global warming problem. The company has already deployed CCS technologies in many of its plants. In CCS technology, CO2 is stored underground, instead of blowing into the atmosphere. BP is planning to store 17 million tonnes of CO2 under CCS (Carbon Capture and Storage Technology, n.d.). BP sells its products under six different brands. The major brand is known as BP itself. It is into oil exploration, refining, solar projects, wind projects and shipping various products of the company overseas. Aral is another brand of BP, which is a famous brand in Germany and provides quality automotive fuels. The other brands under BP are Arco, Castrol, Ampm and Wild Bean Cafe. While, Arco is the provider of clean and low cost fuels in US, Castrol is the worldwide leading engine oil. Ampm is the convenience shop brand in Western USA and Wild Bean Cafe provides world class coffee and affordable food. Objective BP's main objective is to produce affordable, safe and secure energy and the creation of shareholders value. Creating a highly diverse energy portfolio with utmost efficiency is the ultimate goal of the company. Along with this, BP also intends to produce sufficient fossil fuel resources. BP wants to be a major contributor to the process of pollution control for a low-carbon future. Efficient manufacturing, processing and delivering of better products are other major objectives of British Petroleum (Our Strategy, n.d.). Layout (structure) The organisation structure of British Petroleum consists of- Chairman The Board Executive directors Non-Executive directors Board Committees Chairman's Committee Nomination Committee Audit Committee Ethics & Environment Assurance Committee Remuneration Committee Methodology (methods used) Ratio analysis has been used to comment on the financial condition of BP. Ratio Analysis Net Profit Margin = Net Income/Revenue Return on Capital Employed = Gross Profit Margin = Current Ratio = Current asset/ current liability Acid Test Ratio = Stock Turnover Period = Cost of goods sold / average stock Debtors Collection Period = (average debtor / credit sales) 365 Note: Since credit sales are not mentioned, the net sales of the company has been considered as credit sales. Creditors Collection Period = (credit purchase/ average creditor) 365 Note: Since credit purchase is not mentioned, so the entire purchase (Annual Report 2008, pg 141) is considered to be the credit purchase. Gearing Ratio Debt-Equity ratio = Total Debt / Total equity Times interest earned = EBIT/ Total Interest Equity ratio = Total equity /Total assets Debt ratio= total debt / total assets Result Ratio analysis Particulars 2008 2007 Net Profit Margin 0.06 0.07 Return on Capital Employed 0.22 0.20 Gross Profit Margin 0.10 0.11 Current Ratio 0.95 1.02 Acid Test Ratio 0.66 0.62 Stock Turnover Period 19.65 9.66 Debtors Collection Period 6.12 1.06 Creditors Collection Period 1275.19 241.43 Debt-equity ratio 0.27 0.28 Time interest earned 80.67 139.26 Equity ratio 0.40 0.40 Debt ratio 0.11 0.11 All the above data are taken from British Petroleum, Annual Report 2008 Industry ratios Particulars BP Chevron Exxon Market Cap: 134.58B 134.75B 331.75B Employees: 92,000 67,000 104,700 Qtrly Rev Growth (yoy): -23.00% -33.10% -30.50% Revenue (ttm): 361.14B 255.11B 459.58B Gross Margin (ttm): 16.18% 28.52% 38.05% EBITDA (ttm): 42.84B 44.54B 78.67B Operating Margins (ttm): 8.72% 13.72% 14.42% EPS (ttm): 670.00% 1167.40% 869.10% (Annual Report and Accounts 2007, n.d.) Net profit margin as well as gross profit margin of BP is almost same in 2007 and 2008. However, the operating margins of Chevron (13.72%) and Exxon (14.42%) are higher than that of BP (8.72%). This is mainly due to the high operating cost of the company and the company has been struggling to cut down this value due its wide diversification and industry competition. BP is managing its investment in the correct manner. ROCE has improved from 20% (2007) to 22% (2008). This is the outcome of investing in the right option at the right point of time. This growth is a good sign for the company on a long term basis. The Acid ratio is maintained at 0.62 (2007) and 0.66 (2008). This means that the company is running short of liquid assets to meet its short term liabilities. The company is able to turn around 60% of its product into cash in the short term. Current ratio value has decreased from 1.02 (2007) to 0.95 (2008). This further indicates that BP is struggling to maintain its operating cycle however; this is not an indication of bankruptcy. BP has the inventory or work in progress level of around 40%; this is not a good sign for the firm. Stock turnover ratio has improved a lot over the year. The value has gone up to 19.65 (2008) from 9.66 (2007). This is a very good sign for the company. Increase in the ratio implies that BP is converting its stock into cash very quickly. The efficiency of conversion has almost doubled in 2008. Therefore, it is said that BP has an efficient inventory management system. The company is collecting its money from its debtors very quickly. But this value has increased from 2 days in 2007 to 7 days in 2008. This increase in number of days may prove to be harmful for the company. Therefore the company should focus on maintaining this value as low as possible. Creditor collection period has increased to 1278 days in 2008 from 242 days in 2007. This is not a good sign, because if the pay off is delayed then the interest liability of the company will increase. So the company should pay off its debt as soon as possible to avoid the consequence of extra interest payment. This can be done by improving its working capital management. Debt / equity ratio of the company is around 0.27. This implies that BP relies more on equity rather than debt. This does not bode well because by opting for more equity capital, the company is maintaining cost of capital. The cost of equity is much higher than that of cost of debt. Time interest earned value has decreased from 139.26 (2007) to 80.67 (2008) in BP. This is another bad indication for the company. The company's effectiveness to cover up its interest payment has decreased by around 200%. Equity ratio of 0.4 indicates that the company has 40% equity in comparison to its assets. It means that the company is capable of maintaining its operation even if its performance in equity market goes down. In BP the debt is maintained only at 11% of the total assets. This is indicated by the debt ratio of 0.11. The company has a wide base of assets to pay off its debt liability. Problems/Opportunities and Possible Effect on Future Financial Statements The company has failed to keep the operating cost under control; this is clearly evident from the balance sheet of the company. The operating cost and the cost of goods sold is increasing over the years. This cost burden will eventually lead to lower profitability, lower operating margin and also low income. But this will also cause the company's tax burden to go down. The company is investing heavily in wind and solar energy production. As the oil layer is depleting due to heavy consumption of petroleum worldwide, this new investment in alternative energy sources can become a great opportunity for the company. Since very few companies are investing in this segment, BP can have the first mover advantage. The company has taken lots of initiatives to control its carbon emission. Today's world is facing the hazard of global warming, and the oil companies have made a major contribution towards this. With its carbon reduction measures, BP will easily differentiate itself from its competitors. Stimulus package from government is also expected in this segment. Green initiative will also improve the image of the company in front of the consumers. Diversification of the company's energy portfolio will certainly reduce the business risk of BP. This is a good sign for manufacturing companies. BP can easily divest from one segment of its business and invest that amount in another segment. The point that is to be kept in mind is the performance of the industry and the expected profit generation. In this way the company can maintain an optimal balance sheet even in the times of energy turbulence. Due to economic recession, the share performance of the companies has come down to a great extent. But BP has ample trust on equity capital. And this aspect is further confirmed by the negative return in the range of -34.5% in 2008. So, the company should restructure its capital allocation. Since underperforming companies in equity market are also likely to face problems during fund raising it may hamper the long term growth of the company. Inventory/Asset Discussion British petroleum uses FIFO (first in first out) method to value its inventories. In this method the inventory valuation is carried out based upon its historic cost rather than its present cost. Inventory is valued even lower than its cost. This method is widely accepted by the companies during unstable market conditions. The fluctuating crude oil price is the main reason behind the adoption of this method. This method will lower the cost of goods sold and thereby help to show higher profit. Higher profit will attract many of the investors to view BP as a lucrative share. This will raise the wealth of shareholders to a great extent. However, in contrast to this, the increase in profit will lead to the increase in the tax liability of the company. This is also one of the reasons for increasing the tax liability of the company. The other driving factor that has induced the adoption of FIFO method to value its inventories is the aim to increase shareholders' wealth. Various methods like adjusted book value approach, capitalised earning approach, cash flow approach, debt assumption approach, discounted cash flow approach and excess earning methods are widely used approaches to value the assets of any company. But BP has not disclosed any of its valuation approach in its balance sheet (Some Common Valuation Methods, n.d.). Application of Accounting Concepts Accrual concept As per this concept, revenue is realised at the time of sales irrespective of its payment. Suppose in 2008 BP has made sales of $1000, but it is yet to take the payment, even though the payment is made in 2009. The debtor turnover ratio can estimate the extent of this kind of figures (Accounting Concepts, n.d.). Consistency concept As per this concept, the company follows same kind of policies and valuation methods are over the years. BP has adopted FIFO valuation methods for years. Consistency concept helps to maintain a consistent image for the stakeholders. The absence of this concept makes it mandatory for the company to disclose the changes along with proper explanation (Accounting Concept and Conventions, n.d.). Materiality concepts According to this concept, even the smallest of transactions must be shown through its financial statements. For example, "Proceeds from disposal of businesses, net of cash disposed" in the cash flow statement accounts for only $11miilion (2008), this value is too small as compared to previous year's figure of $2518 million. This is a mandatory figure that must be disclosed for the clear understanding of company' cash flow from operating activities (Williamson D., n.d.). Going concern Going concern valuate the company with optimistic approach. Going concern has kept the growth pace of BP over the years and its capability to invest more in profitable ventures (merger and acquisitions with reference to balance sheet). BP is also diversifying its energy portfolio through investments in renewable energy sources (Accounting Concept and Conventions, n.d.). References Accounting Concepts, [No Date], [Online], Available: http://nos.org/320courseE/L-3%20ACCOUNTING%20CONCEPTS.pdf, [1st May 2009] Accounting Concept and Conventions, [No Date], [Online], Available: http://tutor2u.net/business/accounts/accounting_conventions_concepts.htm, [1st May 2009] Annual Report and Accounts 2007, British Petroleum plc., [No Date], [Online], Available: http://www.bp.com/liveassets/bp_internet/globalbp/globalbp_uk_english/set_branch/STAGING/common_assets/downloads/pdf/ara_2007_annual_report_and_accounts.pdf, [1st May 2009] Annual Reports and Accounts 2008, British Petroleum plc. [No Date], [Online], Available: http://www.bp.com/liveassets/bp_internet/annual_review/annual_review_2008/STAGING/local_assets/downloads_pdfs/BP_annual_report_accounts_2008.pdf, [1st May 2009] Carbon capture and storage technology, [No Date], [Online], Available: http://www.bp.com/sectiongenericarticle.docategoryId=9025184&contentId=7048165, [1st May 2009] Direct Competitor Comparison, [No Date], [Online], Available: http://finance.yahoo.com/q/cos=BP, [1st May 2009] Our Strategy, [No Date], [Online], Available: http://www.bp.com/sectiongenericarticle.docategoryId=9027969&contentId=7050936, [1st May 2009] Solar Technology, [No Date], [Online], Available: http://www.bp.com/sectiongenericarticle.docategoryId=9025185&contentId=7048183, [1st May 2009] Some Common Valuation Methods, [No Date], [Online], Available: http://www.smallbusinessnotes.com/financing/valuationmethods.html, [1st May 2009] Wind Technology, [No Date], [Online], Available: http://www.bp.com/sectiongenericarticle.docategoryId=9026131&contentId=7048184, [1st May 2009] Williamson D., [No Date], [Online], Available: http://www.duncanwil.co.uk/conf.htm, [1st May 2009] Read More